By Leika Kihara

TOKYO (Reuters) -Japan downgraded first-quarter gross domestic product (GDP) on Monday and the service-sector business mood soured in June on concerns over rising costs, offseting a lift in factory confidence and pointing to weakness in consumption.

But the "tankan" quarterly survey showed firms planned to ramp up capital expenditure and projected inflation to stay around the Bank of Japan's target of 2% in coming years, keeping alive market expectations of a near-term interest rate hike.

The findings, which come ahead of the BOJ's next policy meeting on July 30 and 31, complicate its decision on how soon to raise interest rates, analysts say.

"The improvement in business sentiment may have peaked, particularly for non-manufacturers. This data doesn't necessarily help the BOJ make the case for an early rate hike," said Toru Suehiro, chief economist at Daiwa Securities.

"But corporate inflation expectations heightened slightly, which will likely keep alive market expectations for a near-term rate hike."

A rare unscheduled downgrade to Japan's historical gross domestic product (GDP) data showed the economy shrank more than reported in the first quarter, which will probably force the BOJ to cut its growth forecasts this month.

Separately, the BOJ's tankan showed service-sector firms were less optimistic in June than three months ago, suggesting a tight job market and soft consumption were hurting sentiment.

An index of big non-manufacturers' sentiment fell to +33 in June from +34 in March, matching market forecasts and worsening for the first time in two years.

By contrast, the headline index measuring big manufacturers' mood rose to +13 in June from +11 in March, exceeding a median market forecast for a reading of +12.

The reading, the highest since March 2022, reflected a rebound in auto output and manufacturers' success in passing on rising costs of raw material through price hikes.

Big firms plan to increase capital expenditure by 11.1% in the current fiscal year ending in March 2025, after a gain of 10.6% in the previous year, the tankan showed.

In a sign of rising inflationary pressure, an index of output prices rose for both manufacturers and non-manufacturers, the survey showed.

Long-term corporate inflation expectations also heightened slightly, with companies projecting inflation to hit 2.3% three years from now and 2.2% five years ahead, the tankan showed.

"Corporate inflation expectations seem anchored at 2%," said Ko Nakayama, chief economist at Okasan Securities. "The tankan is a tailwind for the BOJ in normalising monetary policy."

The Nikkei stock average Monday up 0.12%, having pared gains after the tankan on expectations that rising inflation prospects will prompt the BOJ to raise rates soon.

GDP MAY AFFECT BOJ RATE HIKE TIMING

The BOJ ended negative interest rates in March on the view that sustained achievement of its 2% inflation target has come into sight. Governor Kazuo Ueda has signaled the chance of more hikes if underlying inflation heads toward 2%, as it projects.

Many market players expect the BOJ to raise rates again this year with some betting on the chance of action in July. Others, however, see hurdles for the BOJ to act so soon.

A revision to historical data showed Japan's GDP shrank an annualised 2.9% in January-March, down from an earlier estimate of a 1.8% contraction, reflecting corrections in past data on construction orders.

The GDP for last year's third and fourth quarters was also revised down.

The revisions, which came on top of recent weak consumption and output data, are likely to affect the BOJ's quarterly growth and price forecasts due at its July 30-31 policy meeting.

Yoshiki Shinke, an economist at Dai-ichi Life Research Institute, expects the GDP revisions to lead to a significant downgrade in this fiscal year's growth forecast.

"I wonder if the BOJ can manage to trim bond buying and hike rates simultaneously in July, when there's a growth downgrade showing the economy was in worse shape than thought," he said.

(Reporting by Leika Kihara; Additional reporting by Yoshifumi Takemoto; Editing by Sam Holmes and Clarence Fernandez)